Non-refundable Deposits May Be Refundable After All

By February 23, 2010 Blog, Litigation, Real Estate Law

The recent California appellate court case of Kuish v. Smith (10 CDOS 1928, February 3, 2010) has reminded us that in the world of California real estate law, the concept of “nonrefundable” deposits is sometimes very illusive.
In this case, Mr. Kuish entered into a contract to purchase Mr. Smith’s waterfront home in Laguna Beach for $14 million. Under the contract and various amendments, Mr. Kuish deposited $620,000 into escrow, with $400,000 of the deposit released to the seller, and the balance held in escrow. The purchase agreement clearly specified that the deposits were to be “non-refundable.” After numerous extensions of the closing date, Mr. Kuish finally cancelled the escrow. That must have been a happy day for Mr. Smith, who then promptly sold the house to a back up buyer for $15 million and refused to return Mr. Kuish’s “non-refundable” deposits.
Mr. Kuish decided he really didn’t mean it when he agreed that the deposits would be non-refundable, and he sued Mr. Smith for return of the deposits. The trial court sided with Mr. Smith, holding that non-refundable meant non-refundable, particularly in this case where “both parties are ‘big boys,’ that is, sophisticated business people [who] understood all the ramifications of their actions in freely negotiating to make the deposits non-refundable.” The appellate court disagreed, however. Based on an earlier California Supreme Court decision, it held that retention of the deposit under these circumstances would constitute an invalid forfeiture under California law, regardless of whether the parties agreed that the deposit would be non-refundable.
The parties might have been able to make the deposits truly non-refundable in a couple of ways. The agreement could have been structured as an option to purchase the property, with the deposits designated as the consideration for granting the option. However, most sellers want to have a binding purchase agreement with their buyer, rather than granting an option. Alternatively, the purchase contract could have included an enforceable liquidated damages clause. To be enforceable in any contract for the sale of real property, a liquidated damages clause requires that the clause be reasonable under the circumstance existing at the time the contract is entered into (the actual damages in the event of default must be difficult to ascertain at that time), (ii) the clause must be separately signed or initialed by both parties, and (iii) if a pre-printed contract form is used, it must be in at least 10 point bold type. In a residential contract, each separate deposit must have its own liquidated damages clause signed by the parties at the time the deposit is made, and the clause is only valid to the extent the deposit is actually paid, and is “reasonable.” Whether a residential deposit is reasonable as liquidated damages depends not only upon the circumstances existing at the time the contract was entered into, but also upon the price and other terms and circumstances of any subsequent sale of the same property if the sale (or contract to sell) is made within six months of the buyer’s default. This last requirement might have prevented Mr. Smith and Mr. Kuish from making the deposits truly nonrefundable even if they had used a liquidated damages clause.
So, don’t rely upon simply providing that a deposit is non-refundable in your purchase agreements; always include a liquidated damages clause. And if you are dealing with residential property be sure to understand that a deposit may be refundable even if a liquidated damages clause is used, particularly in a rising real estate market (if and when such a market returns).
Thomas B. Jacob, Real Estate Group